The Securities and Exchange Commission needs to simplify proposed rules to require more disclosure from funds touting their environmental, social and governance factors, or else the agency will fail to eradicate so-called greenwashing, investment and advocacy groups are warning.

Investors of all sizes, including ESG-focused ones, as well as financial advisers and portfolio screeners, agreed that the agency has the proper intent in wanting more clarity from funds that claim sustainable factors. In a series of comment letters filed this week, however, the firms spelled out concerns that the rule as currently written would create confusion, increase compliance costs, and could allow funds to create a false impression of sustainability levels, or greenwashing, a practice in which a firm overstates its environmental concern.

The SEC voted 3-1 in May to propose requiring mutual and exchange-traded funds purporting to consider ESG factors to provide investors information about those factors, their strategies, and the criteria used to achieve their investment goals. SEC Chairman Gary Gensler said at the time that the proposal will help investors better understand what funds and advisers mean when they claim to be sustainable.

Comments were due Tuesday.

One of the top complaints from the industry is the proposal’s plan to divide funds into three categories: integration funds, which incorporate ESG factors among many other considerations; funds that focus on at least one or more ESG factors by using them as a significant or main consideration in selecting investments; and impact funds that have a core ESG objective, as opposed to a financial objective.

Integration funds, the lowest tier, would be required to summarize how they incorporate ESG into the decision-making process, such as which particular ESG factors the fund considers and their level of importance in the investment selection process. They would also have to explain how they consider greenhouse gas emissions in the portfolios if the funds reference emissions as a specific factor. 

The SEC’s definition of an integration fund might go beyond what a lot of fund managers that mention ESG might actually be considering, said Aron Szapiro, head of retirement studies and public policy at Morningstar Inc. 

“It’s not clear to us if these funds would drop the mention of ESG in their prospectus and the use of it, which could be useful in avoiding risks, or if they would say, ‘yeah, we are an integration fund’ and explain what they’re doing, but it might be too confusing to investors,” Szapiro said in an interview.

“The issue here is that we don’t really want funds that use ESG in an incidental or occasional way,” he added. “It’s not core to what they’re doing to be defining themselves as integration funds. I just think that word is confusing.”

Meanwhile, ESG-focused funds would have to go further, such as using a tabular format to report their considerations, and disclosing whether they use proxy voting or engagement with companies as a significant part of their strategies. They would also have to report their use of third-party data, including any ESG scores or ratings. 

In addition, focused funds would have to show their portfolio’s total carbon footprint and weighted average carbon intensity.

ESG impact funds would face those requirements and more. These funds would have to explain their ESG goals, identify how they measure progress toward those objectives, and explain the timeline for meeting the goals as well as the relationship between the fund’s stated impact and its financial returns. 

But current and emerging funds are unlikely to perfectly fit into the SEC’s proposed categories, industry observers said.

“We are concerned that the Proposal’s division of funds into three separate categories does not reflect the reality of how fund managers incorporate ESG factors in investment and stewardship decision-making, which could increase compliance costs,” As You Sow CEO Andrew Behar said in a letter to the SEC.

That would ultimately affect the level of disclosure among ESG investment products and some funds may opt to call themselves integration funds rather than ESG-focused to get away with fewer requirements, industry observers added.

Misleading about sustainability

Several progressive advocacy groups, including the Americans for Financial Reform Education Fund and Public Citizen, asked the SEC to remove the ESG integration category on the grounds that the category may make consumers believe their investments in integration funds are more sustainable than they actually are.

Meanwhile, investors and ESG proponents, including As You Sow, US SIF, Veris Wealth Partners and Everence Capital Management, called on the agency to get rid of the tier system altogether.

“Any funds that claim to use ESG related factors should be required to disclose the same information to investors so that investors have comparable information for each fund, regardless of where that fund falls on the ESG spectrum,” said Holly Testa, director of shareowner engagement at First Affirmative, an investment advisory firm that oversees $900 million in assets under management and advisement.

The Investment Company Institute, a trade association for regulated investment funds, slammed the proposal as “overly complex and prescriptive.” ICI — whose members include BlackRock, J.P. Morgan Chase & Co. and Morgan Stanley — added that the rule as written “risks sowing confusion among investors while imposing significant compliance burdens on funds.”

In a Aug. 16 statement, ICI President and CEO Eric Pan called on the SEC to modify the proposal to give funds the right to opt into ESG disclosures by determining their principal investment strategies and letting the commission know whether or not ESG plays a key role.

“We believe it is critical that investors understand the differences between environmental, social, and governance funds and non-ESG funds,” Pan said. “We recognize that confusion over ESG is undesirable to those investors who want to pursue ESG-related investment strategies and those who do not.”